National Bureau of Economic Research (NBER), September 7, 2011.
The paper explores a New Keynesian Model with diverse beliefs and studies the impact of this heterogeneity on fluctuations and monetary policy. The model used is standard (e.g. Galí (2008), Walsh (2010) and Woodford (2003)). Aggregation is examined only for the log-linearized economy and even for this economy, aggregation problems are significant and their solutions depend upon the belief structure.
Agents’ beliefs are described by individual state variables and satisfy three Rationality Axioms. Belief rationality plays a key role in driving belief dynamics and mean market belief is the main tool used to solve the aggregation problems. Macro dynamics is then described by an IS curve, Phillips curve and a monetary rule which are similar to standard models except that mean market belief is a new force amplifying macro fluctuations. Due to belief heterogeneity, changes in the policy rule alter key macro-economic parameters which must be deduced from the micro equilibrium, a problem not present in a single agent economy. In addition to belief rationality agents know the equilibrium map...